Economics 101A

(Lecture 26, Revised)

Stefano DellaVigna

December 4, 2003

Outline

1. Barter

2. Walrasian Equilibrium

3. Example

4. An Example of Excellent Economics

5. Unsolicited advice

Barter
Consumers can trade goods 1 and 2

Allocation
of barter if:

1
1
2
2
(x1 , x2 ), (x1 , x2 ) can be outcome

Individual rationality.

i) u ( i , i ) for all i
,
x
ui(xi
i 1 2
1
2

1
1
2
2
Pareto Eciency. There is no allocation (
x1, x
2), (
x1, x
2 )

such that

i) for all i
xi1, x
i2) ui(xi
,
x
ui(
1
2

with strict inequality for at least one agent.

 Barter outcomes in Edgeworth box

Endowments (1, 2)

Area that satisfies individual rationality condition

Points that satisfy pareto eciency

Pareto set. Set of points where indierence curves

are tangent

 Contract curve. Subset of Pareto set inside the

individually rational area.

Contract curve = Set of barter equilibria

Multiple equilibria. Depends on bargaining power.

Bargaining is time- and information-intensive procedure

What if there are prices instead?

Walrasian Equilibrium
Prices p1, p2
Consumer 1 faces a budget set:

p1x11 + p2x12 p111 + p212

How about consumer 2?

Budget set of consumer 2:

p1x21 + p2x22 p121 + p222

or (assuming x1i + x2i = i)

1
1
1
1
p1( 1x1)+p2 1 x2 p1 1 1 +p2 2 2

or

p1x11 + p2x12 p111 + p212

1), (x2, x2), p, p

(x1
,
x
1
2
1
2
1 2

Walrasian Equilibrium.
is a Walrasian Equilibrium if:

Each consumer maximizes utility subject to budget constraint:

i
i
i
i
(x1 , x2 ) = arg max ui (x1, x2
xi1,xi2
s.t. p1xi1 + p2xi2 p1i1 + p2 i2

Markets clear:
2
1
2
x1
j + xj j + j for all j.

 Compare with partial (Marshallian) equilibrium:

each consumer maximizes utility
market for good i clears.
(no requirement that all markets clear)

 Graphical depiction in Edbeworth box. Set of optimal points as prices p1 and p2 vary.

Draw oer curve for consumer 1 (equivalent of demand curve in partial equilibrium):
1
(x1
1 (p1, p2, ( 1, 2)) , x2 (p1, p2, ( 1, 2)))

Oer curve is set of points that maximize utility as

function of the varying prices p1 and p2.

Draw oer curve for consumer 2.

 Walrasian Equilibrium is at intersection of the two

oer curves!

Walrasian Equilibrium is a subset of barter equilibrium:

Does satisfy individual rationality?

Does it satisfy the Pareto Eciency condition?

Is any point in Contract Curve a WE for allocation ( 1, 2)?

Example
Consumer 1 has Leontie preferences:

u(x1,x2) = min x11, x12

Bundle demanded by consumer 1:

p1 11 + p212
1
1
1
x1 = x2 = x =
=
p1 + p2
11 + (p2/p1) 12
=
1 + (p2/p1)

 Consumer 2 has Cobb-Douglas preferences:

.5 .5
2
x22
u(x1,x2) = x1

Demands of consumer 2:
x2
1 =
and
x2
2 =

.5 p111 + p212

p1

.5 p111 + p212
p2

p
= .5 11 + 2 12
p

p1 1
= .5
1 + 12
p2

!
!

 Impose Walrasian equilibrium in market 1:

2
1
2
x1
1 + x1 = 1 + 1

This implies
11 + (p2/p1) 12
+ .5
1 + (p2/p1)

p
11 + 2 12 = 11 + 21
p1

An example of Excellent Economics

Savings Rate in the US very low: essentially zero in
year 2,000

Perhaps: Self-control Problem

People would like to save but...Not today!

Credit cards and (too) high borrowing rates

 Is this testable?

Prediction of hyperbolic discounting theory:

people do not like to save today
people like to save tomorrow

Save Tomorrow?

 Benartzi and Thaler (2002): Design of Save More

Tomorrow (SMT) Plan
401(k) private savings or retirement

SMT Plan:
No increase in savings today

3% automatic increase in savings at time of paycheck raise

can drop out at any time

 Advantages:
No current increase

Commit today for future

Use inertia/procrastination the good way!

No decrease in nominal salary (loss aversion)

Option out

 The facts:
1998: mid-size company, 315 eligible employees
you guys are saving too little!
79 employees: increase savings now
162 employees: no increase now, will try SMT
158 employees: remain in SMT plan for two years

Eect: savings rate up from 3.5 to 11.6 percent!

In three years!

Advice

1. Listen to your heart

2. Trust yourself

3. Take good risks:

(a) hard courses
(b) internship opportunities
(c) research URAP
(d) (graduate classes?)

4. Learn to be curious, critical, and frank

5. Be nice to others! (nothing in economics tells you

otherwise)